Working capital management

Working Capital Management

By: Navin Chandra

A Few Facts…• Every Business requires Funds for financing day to day

operations.• Requirement of these Funds varies according to various

factors like nature of business, size, technology, production policy, creditability, operating efficiency etc.

• These Funds are available from various Long Term and Short Term sources.

• Cost of Long Term Sources of Funds is more than that of Short Term Funds. Similarly rate of return from Long Term Asset is more than that of Short Term Asset.

• Shortage of these Funds may lead a Business to Technical Insolvency due to default in payment of dues. It may ultimately result in Bankruptcy.

A Few Facts…

Fixed Assets

ProductionProcess

Generates

Inventory

Sales Generated

Accounts receivable

Used in

Raw Materials, Labour and Variable expenses

Accrued FixedOperatingexpenses

Cash

Suppliers ofLong Term Funds

External Financing

Return on Funds Invested

Collection process

Used topurchase

Used for

Used in

WorkingCapitalcycle

Resource flows for a manufacturing Organisation

Definition of Working Capital

• Working Capital refers to that part of the Organisation’s capital which is required for financing short-term or current assets such as cash, debtors and inventories.

• Working Capital is also known as revolving or circulating capital or short-term capital.

Concept of working capital …• Two interpretations are possible: - Balance sheet concept

- Operating cycle concept

Balance sheet concept• Gross Working Capital= Total Current Assets• Net Working Capital = Total Current Assets - Total Current Liabilities

Concept of working capital …WORKING CAPITAL

(WC)

ON BASIS OF CONCEPT

ON BASIS OF TIME

Gross WC

Net WC Permanent or Fixed

WC

Temporary or Variable

WC

Special WC

Seasonal WC

Concept of working capital …Operating cycle concept

Operating Cycle= Inventory Conversion Period + Receivables Collection Period

Cash Cycle = Operating Cycle – Payment Deferral Period-An Organisation’s Cash Cycle consists of following activities:

• Purchasing resources and making payment • Producing the product • Selling the product and receiving money

Payable Deferral Period

Inventory Conversion

PeriodCash Cycle

Operating Cycle

Pay forResourcespurchased

Receive Cash

Purchaseresources

SellProducton credit

Receivable Collection

Period

Operating cycle of an Organisation

MANAGEMENT OF WORKING CAPITAL

• Refers to management of current assets and current liabilities consistently in an efficient manner.

• Working Capital Management Policies of an Organisation greatly affect its profitability, liquidity and financial health.

Liquidity, Profitability & Risk

Composition & Level

of Current Assets

Composition & Level

of Current Liabilities

Dimensions of Working Capital Management

Optimum Level of Current Assets…

Assumptions• Maximum production:

50,000 units per year• Production process is

evenly spread out during the year

• Current Assets Levels: High Level : A Average Level: B Low Level : C

Optimum Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

AS

SE

TS

LE

VE

L

Current Assets

CC

AA BB


Liquidity AnalysisApproachApproach LiquidityLiquidity AA HighHigh BB AverageAverage CC LowLow

Higher level of current asset lead to more liquidity.

Impact on Liquidity

0 25,000 50,000OUTPUT (units)

AS

SE

TS

LE

VE

L

Current Assets

CC

AA

BB


Return on Assets Return on Assets =

Net Profit X100Net Profit X100Total AssetsTotal Assets

Current Assets Current Assets = (Cash + Receivables + Inventory)

Return on Assets Return on Assets =

Net Profit X100Net Profit X100Current AssetsCurrent Assets+ Fixed Fixed

AssetsAssets

Impact on Profitability

0 25,000 50,000OUTPUT (units)

AS

SE

TS

LE

VE

L

Current Assets

CC

AA

BB


Profitability AnalysisApproachApproach ProfitabilityProfitability AA LowLow BB AverageAverage CC HighHigh

As current asset levels decline, total assets will decline and the ROA will increase.

Impact on Profitability

0 25,000 50,000OUTPUT (units)

AS

SE

TS

LE

VE

L

Current Assets

CC

AA

BB


• Lower cash reduces the Organisation’s ability to meet its financial obligations. Greater risk!Greater risk!

• Stricter credit policies reduce receivables and possibly lose sales and customers. Greater risk! Greater risk!

• Lower inventory levels increase stock outs and lead to loss of sales. Greater risk!Greater risk!

Impact on Risk

0 25,000 50,000OUTPUT (units)

AS

SE

TS

LE

VE

L

Current Assets

CC

AA

B B


Risk AnalysisApproachApproach RiskRisk AA LowLow BB AverageAverage CC HighHigh

Risk increases as the level of current assets are

reduced.

Impact on Risk

0 25,000 50,000OUTPUT (units)

AS

SE

TS

LE

VE

L

Current Assets

CC

AA

BB


SSUMMARYUMMARY O OFF O OPTIMUMPTIMUM C CURRENTURRENT A ASSETSSSETS A ANALYSISNALYSIS

ApproachApproach LiquidityLiquidity ProfitabilityProfitability RiskRisk AA High High Low Low Low Low BB AverageAverage Average Average Average Average CC Low Low High High High High

1. Profitability varies inversely with Liquidity. 2. Profitability moves together with risk. (remember- higher the risk, higher the returns)

Approaches to Current Assets Financing

Approaches to Financing Mix

The Hedging or Matching Approach

The Conservative

Approach

The Aggressive Approach

Hedging approach to assets financing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

Short-termSources

Long-termSources

Amount

Conservative approach to assets financing

Fixed Assets


Total Assets


Time

Short-termSource

Long-termSource Amount

Aggressive approach to assets financing

Fixed Assets


Total Assets


Time

Short-termSource

Long-termSourceAmount

Concept of Operating cycle•Maximization of share holders’ wealth of an Organisation is possible only when there are sufficient returns from the operations.•Successful sales activity is necessary for earning profit. But sales are not converted into cash immediately.•There is time gap between the sale of goods and receipts of cash. •The time taken to convert cash into cash (Cash-Raw Material-Work in Progress-Finished Goods-Receivables-Cash) is known as operating cycle.

Operating cycle of a Trading Organisation

Cash

Receivables

Stock in Trade

Cash

RawMaterials

W I P

Finished Goods

Receivables Sales

Operating cycle of a Manufacturing Organisation

Ascertaining Operating Cycle and Cash Cycle for a Trading Organisation

Operating Cycle= Inventory Conversion Period(ICP) + Receivables Collection Period(RCP)

Cash Cycle = Operating Cycle – Payment Deferral Period (PDP)

ICP = Average Inventory X365 Cost of good sold

RCP = Average Accounts Receivable X365 Net Credit Sales

PDP = Average Accounts Payable X365 Net Credit Purchases

• X Limited has provided following information:• Sales Rs.4,000 Lacs • Inventory - Opening Rs. 610 Lacs ; Closing Rs. 475

Lacs • Receivables- Opening Rs. 915 Lacs; Closing Rs. 975

Lacs• Payables- Opening Rs. 355 Lacs; Closing Rs. 410 Lacs• Cost of Goods Sold: Rs. 2,675 Lacs Compute the Operating Cycle and Cash Cycle.

Ascertaining Operating Cycle and Cash Cycle for a Trading Organisation

Ascertaining Operating Cycle and Cash Cycle for a Manufacturing Organisation

Operating Cycle= Raw Material Conversion Period (RMCP) + Work in Progress Conversion Period (WIPCP) +

Finished Goods Conversion Period (FGCP)+ Receivables Collection Period(RCP)

Cash Cycle = Operating Cycle – Payment Deferral Period (PDP)

RMCP = Average Inventory of Raw Material X365 Raw Material Consumed

WIPCP = Average Inventory of WIP X365 Cost of Production

FGCP = Average Inventory of Finished Goods X365 Cost of Goods Sold

Working Capital Estimation… • Factors to be considered:

– Total costs incurred on materials, wages and overheads.– The length of time for which raw materials remain in store before

they are issued to production.– The length of the production cycle or WIP, i.e., the time taken for

conversion of Raw Material into Finished Goods.– The length of the Sales Cycle during which Finished Goods are kept

waiting for sales.– The average period of credit allowed to customers.– The amount of cash required to pay day-to-day expenses of the

business.– The amount of advance payments if any.– The average period of credit to be allowed by suppliers.– Time – lag in the payment of wages and other overheads.

Working Capital Estimation…

Particulars Amount (Rs.)

Current Assets(i) Cash ----(ii) Receivables ( For…..Months’ Operating Cost) ----(iii) Stocks ( For……Months’ COGS) ----(iv)Advance Payments if any ----Less : Current Liabilities(i) Creditors (For….. Months’ Purchases) ----(ii) Lag in payment of expenses -----_WORKING CAPITAL ( CA – CL ) xxxAdd : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

Particulars Amount (Rs.)

Current Assets(i) Cash ----(ii) Receivables ( For…..Months’ Operating Cost) ----(iii) Stocks ( For……Months’ COGS) ----(iv)Advance Payments if any ----Less : Current Liabilities(i) Creditors (For….. Months’ Purchases) ----(ii) Lag in payment of expenses -----_WORKING CAPITAL ( CA – CL ) xxxAdd : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

Statement of Working Capital Required-Trading Concern

MANUFACTURING CONCERNSTATEMENT OF WORKING CAPITAL REQUIRED

Amount (Rs.)Current Assets(i) Stock of R M( for ….months’ consumption) -----(ii)Work-in-progress (for…months’ production) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads -----(iii) Stock of Finished Goods ( for …months’ COGS) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads -----(iv) Sundry Debtors ( for …months’ operating Cost) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads -----(v) Payments in Advance (if any) -----(iv) Balance of Cash for daily expenses -----(vii)Any other item ----- ________________ Less : Current Liabilities(i) Creditors (For….. Months’ Purchases) -----(ii) Lag in payment of expenses -----(iii) Any other -----___WORKING CAPITAL ( CA – CL ) xxxAdd : Provision / Margin for Contingencies ----- _________________NET WORKING CAPITAL REQUIRED XXX

Prepare an estimate of Working capital requirement from the following information of a trading concern:

Projected annual sales 100000 units

Selling price Rs 8 per unit

% age of Gross profit on sales 25%

Average Credit Period allowed to customer 8 weeks

Average Credit Period allowed by supplier 4 weeks

Average stock holding in terms of sales requirement 12 weeks

Provide for Contingencies 10%


Working Capital Estimation…Special Points:•Profits should be ignored while calculating working capital requirements for the following reasons:

(a) Profits may or may not be used as working capital(b) Even if these are used, these may have to be reduced

by the amount of Income tax, Drawings, Dividends etc.•Calculation of WIP depends on the degree of completion as regards to materials, labour and overheads. •Calculation of Stocks of Finished Goods at cost of Goods Sold and that of Receivables at COGS+ Operating Expenses.•Depreciation should be ignored in Working Capital Estimation as it is non-cash expense.

Prepare a statement of working capital required, Profit & Loss Account and Balance Sheet from following Figures:

• Share Capital Rs.1,50,000• 8% Debentures Rs.2,00,000• Fixed asset Rs.1,30,000The Cost Component is made up as follows:• Material 40%• Direct Labour 20%• Overheads 20%


• It is proposed to maintain a level of activity of 2,00,000 units per annum

• Selling price is Rs. 12/- per unit• Raw Material are expected to remain in store for

an average period of one month.• Material will be in process on average for half a

month. • Finished goods are required to be in stock for an

average period of one month. • Credit allowed to debtors is two months.• Credit allowed by supplier is one month.


THANK YOU

Working capital management

Economy & Finance

Transcript of Working capital management